Tax investigations and methods used during investigations
Income tax returns filed by taxpayers are often incorrect. Sometimes they are incorrect due to simple mistakes, accidents, oversights, confusion, or misinterpretation of the law. Sometimes they are incorrect due to gross negligence or reckless disregard for the law. And sometimes they are incorrect because the taxpayer intentionally and knowingly intended them to be incorrect in order to purposely pay less income tax. Whatever the reason, when incorrect statements are identified, they must be corrected, either immediately or after the conclusion of any criminal proceedings that may be initiated.
When tax inspectors or investigators confront taxpayers to find out why the income tax return is incorrect and seek their cooperation in correcting it, the taxpayer will either cooperate or not. When the taxpayer cooperates, it becomes much easier to determine how much actual income the taxpayer earned, or what expenses are actually allowable under the law, in order to arrive at the correct amount of tax. Cooperative taxpayers may provide their books and records or other documents and assist the inspector or investigator in their attempt to determine how much additional income tax the taxpayer must pay.
When taxpayers do not cooperate, the inspector or investigator may be faced with a serious dilemma. How can they determine how much additional income tax the taxpayer must pay, if any. They must resort to other methods to obtain the information necessary to calculate the true tax owed by the taxpayer.
During a tax criminal investigation, the investigator is required to identify the amount of income that is not reported on the income tax return and also identifies the expenses that are on the income tax return and are not allowed by law to be included in the declaration. . It is generally not possible to be exact in determining the amount of income, nor is it necessary to identify the exact amount of unreported income. The unreported amount must be substantial, relative to the reported amount, if any. Small cases, where minor amounts of income are not reported, are not the type of cases that the tax investigator should identify and investigate. The tax investigator must always be alert to significant cases using the criteria, to identify and document the amount of income that is not declared, or to identify expenses not allowed by law that have been deducted in the tax return, the investigator must identify and gather evidence. This is not an easy task. When taxpayers don’t cooperate, it becomes a very difficult task.
In the world of financial investigation, there are methods and techniques available for the investigator to recalculate or reconstruct the true income and expenses of the taxpayer, even without their cooperation, or even without their books and records. In fact, as the tax investigator enters the world of criminal justice, where the taxpayer commits fraud and therefore could face prison, taxpayers are likely to become less cooperative. Therefore, the tax investigator must acquire skill in the use of available techniques to recalculate or reconstruct a taxpayer’s income and expenses.
However, before explaining these methods, the investigator must fully understand what an income tax return represents and how it relates to the taxpayer’s accounting books, commonly called books and records. The next section explains how the daily business activities of buying and selling relate to a tax return. While this section may seem elementary or basic, a review of the nature of an income tax return will clarify the use of the Specific Transactions Method of Reconstructing Income, the most common and effective method available for reconstructing a taxpayer’s income. , when the taxpayer does not cooperate.
Income tax returns filed by taxpayers are required by the Income Tax Law to contain a summary of all financial transactions made by the taxpayer during the tax year. The summary must include all transactions in which the taxpayer incurred an expense or other deduction permitted by law through an outlay or disbursement of funds. You must also include all transactions in which the taxpayer received or earned money from the sale of a product or service.
In general, when the total of all transactions in which funds were received exceeds the total of all transactions in which funds were expended, the taxpayer has a net profit, which is the amount on which the tax is based. When the total of all transactions in which funds were spent exceeds the total of all transactions in which funds were received, the taxpayer has incurred a net loss and no tax is required to be paid.
Of course, each specific expense must be permitted by law to be included on the income tax return, and each specific receipt of funds must be taxable under the law to be required to be reported on the income tax return. income tax. Expenses incurred that are not allowed by tax laws must still be reported in the taxpayer’s books and records, but should not be included on the income tax return. Likewise, the receipt of funds that are not classified as taxable funds must be reported in the books and records of the business, but not included in the income tax return.
In addition, under the accrual of expense and income method, some expense items may be included in the income tax return even though no actual expenses have been incurred, and some items may be included as income even though no funds have actually been received. .
If the taxpayer makes specific financial transactions during the year that should be included in the summary of expenses and receipts, but are not, then the income tax return is incorrect.
For example, if the taxpayer makes a financial transaction in which they sell a product or service but does not report the receipt as gross income or gross income, then the income tax return is incorrect. Similarly, if a taxpayer includes on his income tax return a financial transaction in which funds were spent on a product or service that is not allowed to be deducted under tax law, the return is also incorrect.
The income tax return is required by law to include all specific financial transactions related to the determination of a gain or loss. When certain specific transactions are not included, the tax investigator must be able to identify which specific transactions were not included and try to gather evidence of the source and the amounts that should be included. Identifying which specific transactions were not reported correctly is known as the Specific Transactions Method.
Other methods of recalculating or reconstructing a taxpayer’s true net gain or loss are based on the total sum or aggregate of all transactions made by the taxpayer during the year. These methods do not identify specific purchase and sale transactions. Instead, the net profit is calculated or reconstructed based on the total of all expenses incurred or the total of all funds deposited in bank accounts.
One of these methods is known as the equity method. This method measures increases in a taxpayer’s net worth between years. Net worth is the amount of assets a taxpayer has accumulated that exceeds the number of liabilities they have accumulated. Increases in net worth are the result of the taxpayer spending money to increase the amount of assets they have or to reduce the amount of debt they have. In addition, a taxpayer’s expenses that do not have lasting value or add to assets, such as expensive airline tickets for personal vacations, are identified and added to their increase in net worth.
The increase in net worth from one year to the next is compared to the amount of income reported on the income tax return. Increases greater than the amount of declared income may be attributable to the fact that the taxpayer does not declare all of his income, since no one can spend more than what they earn. The excess is charged to the taxpayer as unreported income. Of course, adjustments must be made, as described in the text below, for loans, gifts, inheritances, and other nontaxable sources of funds.
Another method is known as the bank deposit method. This method compares the total amount of funds deposited in all bank accounts during the year with the gross income reported by the taxpayer on their tax return. Bank deposits in excess of gross income are charged to the taxpayer as unreported income. Again, certain adjustments must be made and other requirements must be met before the excess can be called unreported income.
The Specific Transaction Method is the most widely used method and the easiest to understand.
All three methods, however, have a common thread. All three require the tax investigator to follow the flow of money, from one person to another. This is accomplished by following the paper trail left by financial transactions. When products are sold, goods are purchased to be consumed in the course of business, or services are provided, often on the basis of a contract, there are generally records that reflect the nature of the transaction, particularly if the amounts are large. Such records include purchase orders, sales receipts, inventory lists, invoices, deposit slips, bank statements, etc. By following the money, tax investigators will find people who can become witnesses who will ultimately produce the evidence the investigator needs to document their case and establish that the taxpayer committed a crime under the Income Tax Law.
Smaller companies may not keep books and records, which would increase the difficulty of addressing non-compliance. There are other methods available to address these types of taxpayers. One common method is to impose an annual license fee on small businesses, rather than requiring a tax return. This method greatly reduces the administrative burden required to collect a small amount of income tax.